Pension funds use interest rate swaps to hedge the interest rate risk arising from their liabilities. Analyzing regulatory data on Dutch pension funds, we find interest rate hedging exposes pension funds to liquidity risk due to margin calls, which can exceed 15% of their total assets when rates rise. We first trace back swap usage to pension regulation and show pension funds with tighter regulatory constraints use swaps more aggressively. After quantifying margin calls, we show pension funds respond to these margin calls by selling safe and short-term government bonds. This procyclical selling adversely affects the prices of these bonds.

We study the extent of interest rate risk sharing across the financial system using granular positions and transactions data in interest rate swaps. We show that pension and insurance (PF&I) sector emerges as a natural counterparty to banks and corporations: overall, and in response to decline in rates, PF&I buy duration, whereas banks and corporations sell duration. This cross-sector netting reduces the aggregate demand that is supplied by dealers. However, two factors impede cross-sector netting and add to substantial dealer imbalances across maturities: (i) PF&I, bank and corporations' demand is segmented across maturities, and (ii) hedge funds trade large volumes with time-varying exposure. We test the implications of demand imbalances on asset prices by calibrating a preferred-habitat investors model with risk-averse arbitrageurs, who face both funding cost shocks and demand side fluctuations. We find that demand imbalances play a bigger role than arbitrageurs’ funding cost in determining the equilibrium swap spreads at all maturities. In counterfactual analyses, we demonstrate how demand shocks, e.g., regulation leading banks to hedge more, affect the hedging behavior of other sectors, such as PF&I. Our paper provides a quantity-based explanation for empirically observed asset prices in the interest rate derivatives market.

Whether maturity transformation exposes banks to interest rate risk depends in part on the effectiveness of bank deposits as a hedge against interest rate shocks. In this paper, we provide evidence that, despite an increase in the average maturity of bank assets, the duration of bank equity was negative for most of the post-financial crisis era. We document that an important factor contributing this was an increase in the average duration of deposits due to a positive relation between deposit betas and the level of interest rates. The dynamic nature of the duration of deposits also explains why deposits provided a poor hedge against recent rate hikes. Overall, we find that variable deposit betas contribute to the negative convexity of bank equity.